Tech Banker

Private Funding Myths

CEO’s make lousy fundraisers.

Okay, we acknowledge that’s meant to be a provocative statement.  CEO’s are critical to successful fundraising but should they go it alone?  Historically, the venture capital community has been highly reticent to engage an investment banker to assist with raising capital.  The usual arguments come out something like this:

1.                  Don’t want to pay a fee

2.                  Part of the CEO’s duties

3.                  Why hire an advisor for a job we can do ourselves.

4.                  Existing investors are funding their pro-rata share, we certainly don’t want to be charged a fee for putting our own money to work.

5.                  Our LP’s are paying us implicitly to get our portfolio companies funded.

6.                  We have lots of VC relationships, our “club” will fund it.

7.                  Always done it ourselves, it works, why change.

8.                  Agented deals are tainted. 

Value Creation Filter

Well, let’s look at this issue from a perspective that places value creation as the sole decision criteria.  We believe that’s a fair filter as VC’s and entrepreneurs are fundamentally seeking to build value as job #1.

1. Don’t want to pay a fee 

Understand.  Question really is whether the investment bank adds more value than they take as a fee.

2. Part of the CEO’s duties

Successful CEO’s delegate aggressively.  The fund raising process doesn’t create value, however building the business does.  CEO’s should use their precious time for the latter.  The CEO, and other senior executives, are critical to the fund raising process but what if 20 hours a week was freed up via an advisor?

3. Why hire an advisor for a job we can do ourselves 

See #2.

4. Existing investors are funding their pro-rata share, we certainly don’t want to be charged a fee for putting our own money to work. 

So, fund it yourself.  The reality is that external capital serves an important role.  It bring external validation, mitigates financial risk, sets valuation and terms eliminating internal arm wrestling, allows a step up (hopefully) in book carrying value and can even reduce execution risk with the right investor.  The new investor(s) are the catalyst of the funding.  Creating and negotiating the catalyst is the value, not how the round is divvied up.

5. Our LP’s are paying us implicitly to get our portfolio companies funded.

Perhaps on the extreme margin this is an accurate statement but lets get back to what LP’s really pay VC’s to do … make them money.  This takes us right back to point #2 above. Is this the highest and best use of a VC’s time?  We bet the answer is no.

6. We have lots of VC relationships, our “club” will fund it. 

Now be honest with yourself, how often did your buddies end up being the next round of funding?  In your hot companies, perhaps more often than not but buddies generally do not represent an “efficient” market.  What about the vast majority of your portfolio, promising but experiencing typical growing pains and executing a bit below expectations.  Do you want to invite your closest friends to share the frustration?

7. Always done it ourselves, it works, why change.

We hope a VC never uttered this, it sounds awfully bureaucrat like.  Yikes!

8. Agented deals are tainted.

Given all the compelling reasons to hire an agent that are outlined above perhaps we should reject this groupthink.

We’ll speak more on this issue in the future.

Tom Evslin

We were disappointed yesterday after reading Tom Evslin's take on the Vonage IPO

Tom is experienced, smart, insightful and has a well read blog with respect within the technology community.  Unfortunately this Vonage post troubled us as it is misleading and does not accurately portray how the IPO process works.  His fact, his core arguments and conclusions are just plain wrong.

The generally subject of his post has little to do with Vonage in particular but rather how underwriters profit from an IPO generally.  He asserts that the over-allotment option (also known as a green shoe) is a mechanism for massive investment banker profits.  In his two hypothetical examples, he suggests that the underwriters would make $20mm if Vonage stock rose by 25% and $33mm if the stock took a 41% dive.   

Well let us set the record straight, investment bankers DO NOT capture these types of returns utilizing the over-allotment option.  As a rule, the only revenue earned by the investment banks on the over-allotment option is the gross spread (commission) by selling the shares, just like the primary shares being offered.  In a typical IPO that is 7% of the proceeds raised.  In fact, the existence of the over-allotment option is purely to assist the underwriter with post-pricing market stabilization and is practically not an effective mechanism for profits. 

We challenge Tom Evslin to get his facts straight and do what he says in his post is necessary:

"You just have to understand what the over-allotment is and what it means."

We'll we watching.

Software Buyouts

Yesterday we attended the JP Morgan technology conference where the lunch panel were some of the who's who of technology buyouts .  The group included Jim Davidson (Silver Lake Partners) Dipanjan Deb  (Francisco Partners) Gene Frantz  (Texas Pacific Group), Jim Neary (Warburg Pincus) and Raj Dapadia (JPMorgan Leveraged Finance).  A few quotes tell the story nicely:

"Don't come to us when you sell a company, come to us when you want to buy your company" (Jim Davidson)

"Looking for two to three good ideas a year" (Jim Davidson)

"Dirty little secret in technology, most businesses don't die" (DJ Deb)

"Key components of value creation are multiple arbitrage and management execution.  Management adds bulk of the value" (DJ Deb)

"Target returns are 25%-30% IRR with a 3-5 year time horizon" (DJ Deb)

"Debt an important piece of the toolkit" (Raj Kapandia)

"Peak leverage these days, 7x cash flow" (Raj Kapandia)

"Ideally looking for software business where data has value.  Marry technology, software and data" (Jim Neary)

"Will see $25 billion plus deal within the next 18 months" (Gene Frantz)

Financial engineering optimization vs. fundamentals of business, investment decision based upon the latter. (Jim Davidson)

Marry stable core business and cash flows with growth component

"Volitility and business cycles an underated investment thesis" (Gene Franz)

"Going private deals will be an important driver of the software industry going forward" (Jim Neary)

Conclusion: some established software companies are excellent buyout candidates and we'll see activity levels likely rise over the next few years, particularly if the debt financing markets continue to be robust.

SOX Follow Up

Quick update on Sarbanes Oxley.  The SEC announced last week that they are standing firm on requiring all public companies to be in compliance with the legislation.  As reported in the NY Times:

"The basic message is the S.E.C. is saying that there is no ultimate postponement for smaller companies," the chairman of the commission, Christopher Cox, said in a telephone interview. "Ultimately, all companies will be required to comply."

The provision has taken effect for most American companies, exempting only those with less than $75 million worth of stock in public hands, but many companies have complained about the cost of the audits. The commission and the board issued guidelines last year aimed at reducing the cost. Those guidelines will now be incorporated into the auditing standard.

We stand by our previous post on this subject.  SOX implementation is a headache, yes, but the notion that it's a material constraint to the IPO market is nonsense.

Peer Production

Umair Haque has done some very interesting work on peer production.  This is a subject that is core to the opensource software movement and Umair's work is very thought provoking.

We'll talk more about this subject in future posts.

Borland Takes a Turn

It’s not often that we have a chance to witness a public software vendor take a strategic 180.  Borland, the venerable development tools vendor, has amassed a corporate history that legends are made.  It’s latest turn may be its most audatious.  Borland recently announced that it is exiting the business that made it famous, for a litany of valid reasons.  They read like a top 10 list of challenges within the software sector.  Open source, Microsoft, pricing pressures, distribution model challenges, one-stop solutions providers,….  In other words, Borland was fighting a multi-front war and it was losing, badly.

So what’s a company to do, well how about buy its way out of trouble.  In February 2006 Borland announced the purchase of Segue Software.  Segue takes Borland from sole focus in the development realm to integrating the production realm as well.  The strategy is to manage software performance througout its life cycle; from development through production.  We’ve always liked the infrastructure management sector and still do.  As the IT environment has gotten more complex, and it always does, getting things to do what they are supposed to do become more difficult.  Lots of fine companies have been built in this realm including CA, BMC, Tivoli (IBM), Quest, Mercury Interactive, Precise (Veritas now Symantec), Wily (CA) among others.

So was this a brilliant strategic move?  Brilliance will only be proven with time.  logical?  Yes.  Borland is starting with a seedling (Segue) that by itself gives them only a start.  This is really a public start-up effort for all intent and purposes.   The public realm is a tough place to figure out how to build a business.  We will be watching closely, not often do public companies reincarnate.

Second Impressions

Over the past year well over 100 companies have presented their business to us while attempting to raise funding.  We focus on expansion stage companies which means there is a product being sold to real customers.  In other words they have the seeds of becoming a real business.  Not surprisingly, almost without exception, the entrepreneurs come prepared to make a strong first impression.  Most do, although most most of the businesses that they are trying to build don't.  Given the high stakes involved to create a new company/getting funding and the reality of how difficult that is, both would be expected.

Second impression however have disappointed.  For some reason the majority of entrepreneurs fail miserably when it comes to crisp, effective follow-up.  Two things pop to mind immediately. First, a simple thank you email or phone call is as rare as snow in Miami.  What ever happened to common courtesy that mom taught us?  I can assure you it's a dying art in Silicon Valley.  I find myself as guilty as anyone in this regard but I've come to realize that it actually can set the tone for the future relationship.  It's so simple, just do it!

The second, and perhaps a more concerning failure, is how poorly most companies respond to requests for additional information.  100% of the time we need more information to be able fully understand the business that we are being asked to invest in.  99.9% of the time the information we get back is one of three things: 1) not what we asked for, 2) incomplete or 3) requires 30 minutes of work just to get it formatted to make if readable or printable.  Unbelievable!

Message to all entrepreneurs: Second impressions matter allot so think about how to improve your batting record.

We'll talk more about this issue in a future post.

Sarbanes Oxley

Yesterday I attended the Always On Hollywood conference via video cast.  The panel on exit strategies hosted by Micheal Montgomery was interesting and at times lively.  There was a subject that was discussed as well called Sarbanes Oxley.  As most know the Sarbanes Oxley Act of 2002 are a set of laws that came into being several years ago in an attempt to rein in the excesses of the late 90's bubble mentality in business.  A detailed overview of the Act can be read at this link, but at their core they require public corporations to put in place systems and processes to ensure that financial statements are accurate and fairly represent the business.  Of course!  That is what all market participant in a law governed society would like to see, so what is the problem?  Nothing, in our opinion, but most in the technology landscape seem to see otherwise.

Tim Draper, a prominent and respected VC, mentioned this as ruining his business yesterday at the Always On Hollywood Conference.  Why, he believes it keeps companies from going public, thereby eliminating, or at least severely limiting, that liquidity option.  On the margin he as a point but I believe Sarbanes Oxley has become the whipping boy for a bigger issue which is there are simply far fewer companies that have achieved levels of success that would allow them the IPO option.  The core of the Sarbanes Oxley argument is that its expensive.  Here is the reality, its does cost money, but for a typical IPO candidate its likely on the order of a $1mm incremental annual expense.  In the context of companies that are at a stage of development appropriate for IPO, it's not material.  It's time to get off this non-issue and focus on building quality companies that have the prospects to excite public company investors.

Finally -- The First Step

I've finally taken the plunge and have all the best intentions to begin a regular blog.  We are Architect Partners LLC, a firm in formation stage, which we hope to debut later this year.  This blog is intended to get my feet wet and begin putting some building block is place for AP.